On Predicting Financial Failure of Karachi Stock Exchange Listed

Textile Firms
1*
Hayat M. Awan, 2 M. Ishaq Bhatti, 3 Muhammad Azeem Qureshi, and 4 Fariha Bashir,

1, 3, 4
Faculty of Management Sciences, B Z University, Multan, Pakistan
2
La Trobe University, Melbourne, Australia

*Corresponding author

Faculty of Management Sciences, B Z University, Multan, Pakistan

Telephone # +92-061-9210056, Fax +92-061-4745540, e-mail: drhayat@bzu.edu.com

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1. Introduction

A financial failure prediction model has different applications. Cybinski (2001), Gibson

(2001), and Altman et al. (1979) suggest that a reliable distress prediction model can be

used by management to take preventive measures. For instance, if the problems of a firm

are temporary and not chronic, the economic value of its assets can be saved and eventual

failure and liquidation can be avoided by making an early decision to merge with a sound

company or by declaring bankruptcy and then attempting to reorganize. The early

liquidation, on the other hand, can be more effective if the value of a firm as a going

concern is less than its liquidation value. Altman (1983) pointed out that developing

countries and smaller economies, as well as larger industrialized nations of the world are

concerned with avoiding financial crisis in the private and public sector and, therefore,

financial failure prediction models being early warnings of financial crisis are also

important for governments. Financial distress prediction model can aid investors in

selecting and disposing of stocks and dividend and price change analysis. Cybinski

(2001), Gibson (2001), and Doumpos and Zopounids (1999) reported that lenders can use

such models in making lending decisions and monitoring the loans. Another application

area of financial distress prediction model is bond ratings. Altman (1983) while

examining the relationship between financial distress measure ZETA and several of

conventional ratings like Moody’s and Standard and Poor’s rating noted that the average

ZETA score was higher for bonds with better ratings. He recommended that distress

prediction model like ZETA can be used as a type of periodic screen to pick up material

discrepancies between model score and existing bond ratings in order to direct the efforts

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of analysts and bond raters in a timely and reliable way to those securities where a change

in risks has just recently occurred. A reliable business failure model can also play an

important role in the overall “audit risk” assessment. The users of financial statements

often consider the qualification or non-qualification on the basis of going concern by

auditors as a prediction of financial failure. Altman (1983) and Persons (1999), however,

found that very few failed companies received qualified audit opinions, while the failure

prediction models showed high accuracy in identifying failed firms. The failure

prediction models are, therefore, quite useful where the auditors do not deem the situation

serious enough to qualify their reports.

The purpose of this study is to develop a financial failure prediction model using

financial variables for Karachi Stock Exchange listed textile firms. The model is

developed for only textile sector listed on Karachi Stock Exchange as Smith and Liou

(2007) suggested that in order to achieve high accuracy separate failure prediction models

should be constructed for different sectors. Here Multivariate Discriminant Analysis

(MDA) and logistic regression are applied to the two groups of healthy and distressed

firms to, firstly, produce a classification instrument and then the derived formula can be

used to predict new cases. There have been a number of previous studies addressing the

prediction of financial failure, for instance the studies by Beaver (1966), Altman (1968),

Altman (1977), Altman et al. (1979), Zavgren (1985), Wallin and Sundgren (1995),

Shirata (1998), Tirapat and Nittayagasetwat (1999), Persons (1999), Sung et al. (1999),

Lee and Yeh (2004), Lin and Piesse (2004), Smith and Liou (2007), and Sharp and

Stadnik (2007).

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As far as the term financial failure is concerned it can be described in many ways.

According to Gibson (2001) different authors use different criteria to indicate failure, for

instance liquidation, deferment of payments of interest on bonds, deferment of payments

of principal on bonds, or the omission of preferred dividend. Doumpos and Zopounidis

(1999) viewed financial distress as a broad concept that comprises several situations in

which firms face some form of financial difficulty. So they defined financial distress as

the situation where a firm cannot pay its creditors, preferred stock holders, suppliers, etc.,

or the firm goes bankrupt according to law. All these situations result in discontinuity of

the firm’s operations, unless proper measures are employed.

This study has used financial ratios for developing a financial distress prediction model

as financial ratios analysis has been a very useful instrument in evaluating companies’

operational and financial problems. Financial ratios of companies moving towards

financial failure tend to differ greatly from those of companies likely to stay healthy. A

study by Beaver published in 1966 is considered a major milestone in financial failure

prediction literature. He was first to list indicators’ based analysis among financial failure

prediction techniques. In his study, he compared the indicators of bankrupt firms one by

one to those observed in a sample of successful firms. He found differences between the

financial indicators of bankrupt and surviving companies. He found signs of insolvency

even five years before actual event and, therefore, gave the evidence that indicator

analysis can be a useful instrument in financial failure prediction. Doumpos and

Zopounidis (1999) viewed that as the financial distress process evolves, the financial

position of distressed firms deteriorates gradually. Healthy firms, on the other hand, have

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a stable, good financial performance through out a specific time period. Thus financial

ratios can be used to distinguish the healthy firms from financially failed ones.

2. Methodology

2.1. Data and sample

The 26 years’ data, from 1972 to1997, analyzed in this research is taken from “Balance

sheet analysis of joint stock companies listed on Karachi Stock Exchange” published by

State Bank of Pakistan. Textile sector is selected for analysis because a sufficient sample

of failed firms is available from this sector to analyze their characteristics and

development of failure prediction model. As far as the definition of financially failed

firms is concerned, most commonly used terms for financial failure are default,

insolvency, and bankruptcy. But the data available for this study does not indicate when a

firm defaulted on its debt or entered into debt restructuring agreement. Therefore the

financially failed firms in this research are defined as those that ceased their operations

and finally de-listed from Karachi Stock Exchange. Financial statement’s data for last

year of operations of these firms is collected and analyzed for development of the model.

For this purpose, 34 firms are identified that failed in textile sector from 1972 to 1997.

Financial data of these firms for up to eight years prior to failure is also collected so that

prediction accuracy of models on this data can be observed. For development of failure

prediction model, failed firms must be matched with surviving firms. In this study,

surviving firms are defined as those that continued their operations and were listed until

1997, and as such 206 firms are identified as surviving firms from 1972 to 1997 in textile

sector and all these firms are included in the analysis. The financial statements’ data of

the year 1996 of these surviving firms is taken for the analysis.

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In this study 32 financial ratios that were used in different financial distress prediction

studies reviewed in literature are analyzed for development of such a model. Another

reason for the selection of these financial ratios is the availability of financial data as

certain ratios used in previous studies cannot be calculated here due to data limitation.

2.2. Method

First of all a univariate test i.e. Wilcoxon rank sum test is applied on the financial ratios

analyzed in this study to identify which ratios can significantly differentiate failed firms

from non-failed firms. Then multivariate techniques (Multivariate Discriminant Analysis

and Logit Analysis) are applied to develop the model.

2.2.1. Univariate analysis

In univariate analysis, according to Hajdu and Viraj (2001) and Altman (1983) the

indicators of failed firms are compared one by one to those observed in non-failed firms

to identify which indicators are good in discriminating failed and non-failed firms.

Beaver in his 1966 study on bankrupt firms used this technique. Examples of univaritate

techniques are: comparison of mean values, maximum likelihood ratio etc. Altman

(1983), while criticizing univariate analysis, stated that in this analysis emphasis is placed

on individual ratios which is potentially confusing and may lead to faulty interpretations.

For instance, a firm with a poor profitability may be regarded as a potential bankrupt.

However, because of its above average liquidity, the situation may not be considered

serious.

2.2.2. Multivariate discriminant analysis

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Hajdu and Virag (2001), Back et al. (1996), Kinner and Taylor (1996), Altman (1983),

and Johnson and Wichern (1988) report that multivariate discriminant analysis is used to

derive the linear combination of independent variables that will discriminate between a-

priori defined groups and this is achieved by the statistical decision rule of maximizing

the between-group variance relative to the within group variance. The discriminant

analysis derives the linear combinations from an equation that takes the following form:

Z = w1 x 1 + w2 x 2 + … + wn x n (1)

Where

Z = discriminant score

w i (i = 1, 2, …, n) = discriminant weights

x i (i = 1, 2, …, n) = independent variables

In financial failure prediction, a discriminant score for each firm is obtained by putting its

values on the independent variables in above equation and this score is then compared to

a cut-off value in order to determine the group to which a company belongs. According to

Back et al. (1996) discriminant analysis is well suited for development of failure

prediction models if the variables in every group follow a multivariate normal

distribution and the covariance matrices for every group are equal. However, they pointed

out that empirical experiments have shown that especially failing firms violate the

normality conditions. In addition, the equal group variances condition is also violated.

2.2.3. Logit analysis

Logit analysis (also called logistic regression analysis) is used to determine the

relationship between binary or ordinal response probability and independent variables by

the method of maximum likelihood (Hadju and Viraj (2001), Back et al. (1996), Persons

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(1999), Maddala (1992), Doumpos and Zopounidis (1999)). This technique assigns a Z

score in a form of failure probability to each company in a sample by allocating weights

to the explanatory variables. Logit analysis uses the following function to predict failure:

Probability of failure = 1/1+e (-Z) = 1/1+e –(w0+w1x1+…+wnxn) (2)

Maddala (1992), Hadju and Viraj (1996), Sung et al. (1999), and Lin and Piesse (2004)

argued that Logit analysis performs better in developing failure prediction model than

Discriminant analysis as it does not have assumptions of normal distribution and equal

covariance matrices. On the other hand Wallin and Sundgren (1995), Back et al. (1996)

empirically proved that failure prediction ability of a model based on multivariate

discriminant analysis is as good as that of Logit model.

3. Empirical Results

3.1. Univariate test

The results of Wilcoxon rank sum test show that:

1. The ratios of Net working capital/Total assets, Net working capital/Total debt,

Current assets/Current liabilities, Cash + Marketable securities/Current liabilities,

Cash flow/Total debt, Cash + Marketable securities / Total liabilities, and Cash

flow / Current liabilities can significantly differentiate failed firms from non-

failed firms (the p-values for these ratios are below 0.05). The mean ranks of

these ratios reveal that failed firms have low level of liquidity than non-failed

firms. The ratio of Current assets/Sales can also discriminate failed firms from

non-failed firms. The mean ranks of this ratio show that failed firms have higher

values on this ratio than non-failed firms. This is because of low level of sales in

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 failed firms. The possibility of failed firms having high value on this ratio because

of higher level of current assets is ruled out as other liquidity ratios reveal that the

current assets in failed firms are not sufficient to meet current liabilities.

2. The leverage ratios like Total debt/Total assets, Net worth/Net fixed assets, Total

equity/Total capitalization, Total equity/Sales, Total equity/Total debt, Total

debt/Total assets, Long-term debt/(Total equity – Short term liabilities) show

significant differences between failed and non-failed firms. Failed firms are more

indebted than non-failed firms. The leverage ratios of Long-term debt/Total

equity and Total debt/Total equity are also found to be good indicators of

financial failure. But the mean scores of these ratios show results contradictory to

other leverage ratios. Mean scores of failed firms are lower on these ratios than

non-failed firms. These ratios thus indicate that failed firms are less leveraged

than non-failed firms. But this is not the reality. Failed firms have lower values on

these ratios because in a number of failed firms, total equity has turned negative

due to accumulated losses. This negative equity or negative denominator results in

negative values on these ratios for failed firms.

3. Failed firms are also less profitable than non-failed firms as it is obvious from the

ratios like Net income/Total assets, Net profit before taxes/Total assets, Net profit

before taxes/Sales, Surplus/Total assets, Cash flow/Total assets, Sales/Total

assets, Gross profit/Total assets.

4. The ratios, Current assets/Total assets, Cash + Marketable Securities/Sales, Net

working capital/Total equity, Cash + Marketable securities/Total assets,

Sales/Fixed assets + Net working capital, Net income/Gross profit, Operating

9
 expenses + Interest/Total assets, are however not found good indicators of

financial failure.

3.2. Failure prediction model and tests

3.2.1. Multivariate discriminant analysis (MDA) based model

In this study, stepwise multivariate discriminant analysis (MDA) is applied on 32

financial ratios to arrive at a failure prediction model. The final discriminant model is as

follows:

Z = 1.034 +0.561X1+0.718X2+2.154X3-3.628X4

Where

X1 = sales / total assets,

X2 = total equity / total capitalization,

X3 = net working capital / total debt, and

X4 = current assets / total assets.

The description of variables included in the model is as follows:

X1, Sales / Total Assets (S/Ta)

“Sales / total assets” or capital turnover ratio represents the sales generating ability of the

firm’s assets. Higher capital turnover ratio is desirable.

X2, Total Equity / Total Capitalization (T Eq./T Cap.)

Here total equity is actually book value of equity and total capitalization includes book

value of equity, current and long term debt. “Total equity / total capitalization” is a

measure of leverage. It shows creditworthiness and financial risk of a firm. In this study

“total equity / total capitalization” ratio is found to be more significant in discriminating

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failed and non-failed firms than other measures of leverage like “market value of equity /

book value of total liabilities”, “Total debt / total assets”, “total debt / shareholders’

equity” etc.

X3, Net Working Capital / Total Debt (Nwc / Td)

Net working capital / total debt ratio is a measure of liquidity. This ratio is also used by

Ko (1982) in his financial distress prediction model for Japan. Net working capital is

defined here as the difference between current assets and current liabilities.

X4, Current Assets / Total Assets (CA / TA)

Current assets / total assets ratio is also a liquidity measure found in studies of corporate

problems. In order to avoid insolvency a firm should have optimal level of “current assets

/ total assets” ratio. An extra ordinary higher CA / TA ratio is however not desirable as

current assets are not operating assets or income generating assets of a firm and a higher

level of “current assets / total assets” indicates that the firm’s revenue generation capacity

is low.

3.2.1.1. Ability of the model to separate failed and non-failed firms

In order to determine the ability of the model to discriminate between failed and non-

failed firms, ANOVA is used. Here the F-statistic is the ratio of sum of squares between

groups (in terms of discriminant score) to the within groups sum of squares. When this

ratio is maximized, it has the effect, of spreading the means (centroids) of the groups

apart and simultaneously, reducing dispersion of the individual points (firms discriminant

score) about their respective group means. According to Altman (1968) this test

(commonly called the F-Test or ANOVA) is appropriate because the objective of the

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MDA is to identify and utilize those variables which best discriminate between groups

and which are most similar within groups. The F-value of 48.44 at 000 significance level

indicates that this MDA model has ability to separate failed and non-failed firms and

therefore the null hypothesis that the observations in the sample come from same

population is rejected.

3.2.1.2. Classification test accuracy

The MDA model is applied on the firms in sample using data compiled one financial

statement prior to failure for failed firms and the respective year data for survivor group.

Once discriminant score for each firm in the sample is calculated, it is assigned to one of

the groups, i.e. failed or survivor, based upon the relative proximity of the firm’s score to

the various group centroids. Here midpoint between the group means i.e. –0.4525 is used

to classify the firms. A firm is allocated to the group of surviving firms if its discriminant

score is ≥ -0.4525, otherwise it is classified as a failed firm. The classification matrix of

the original sample is shown in Table 1. The model is accurate in classifying 172 firms

out of the sample of 206 non-failed firms (i.e. 83.5% accuracy in non-failed firms’

classification) and 25 firms out of the sample of 34 failed firms (i.e.73.5% accuracy in

failed firms’ classification).

3.2.1.3. Validation test

Since the resulting accuracy is biased upward by (1)Sampling errors in the original

sample; and (2)Search bias (resulting from the process of reducing the original set of

variables to the best variable profile) when the firms used to determine the discriminant

coefficients are reclassified (Altman, 2000), it is appropriate to apply validation test at

this stage.

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Lachenbruch (1967) Test (also known as Jacknife Method) is used here as validation test.

This procedure isolates one firm from the original sample and isolate it for testing its

classification accuracy based on a model developed from the remaining N-1 observations

(N is the size of total sample). This process is repeated N number of times and individual

observations’ classification accuracy is then cumulated to give an almost unbiased

estimate of the expected accuracy of the model. Since this method allows the use of all

available data in the estimation, Kahya and Theodossiou (1999) state that this method is

superior to the holdout method and results in a statistically more reliable model. The

result of the validation test is given in Table 1.

Since the accuracy of the model is almost same after applying Jacknife method i.e. 82%

for non-failed firms and 73.5% for failed firms, the model possess discriminating power

on observations other than those used to establish the parameters of the model. Therefore,

any search bias does not appear significant.

3.2.1.4. Establishing a practical cutoff point

Persons (1999) suggested that an optimal cutoff point selected is not the one that

minimizes total classification error of sample but the one that minimizes the following

expected cost function, E(C):

E(C) = WFEF + WSES (3)

WF and WS are the weights attached to EF (i.e. type I error rate i.e. rate of misclassifying

a failing firm as surviving) and ES (i.e. type II error rate i.e. rate of misclassifying a

surviving firm as failing). The weights WF = PFCF/(PFCF + PSCS) and WS = PSCS/(PFCF +

PSCS) are functions of:

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 1. Prior probabilities PF and PS = 1-PF which measures the actual proportion of

failing and surviving firms in the population,

2. The costs CF and CS associated with the misclassification of failing and surviving

firms.

In this study equal weights are used (WF = WS = 0.5). The choice of equal weights is also

recommended by Kahya and Theodossiou (1999) because the prior probability for failing

group is smaller than that of surviving group, whereas the cost of misclassifying failing

firm is larger than that of surviving firms. Prediction accuracy for failed and non-failed

firms, and expected cost function (EC) at different cutoff points is shown in Table 2.

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EC is minimum i.e. 20.52% at the critical value –0.55. At this point classification

accuracy for failed firms is 73.53% while 85.43% for non failed firms. –0.55 is therefore

chosen as the cutoff point that discriminates best between the failed and surviving firms.

3.2.1.5. Long range accuracy of the model

In order to determine the overall effectiveness of the discriminant model for a longer

period of time prior to failure, data are gathered for the 34 failed firms for two to eight

years prior to failure and MDA model is applied on it. Similarly for non-failed firms data

are gathered for seven years prior to their respective data year in the original sample (i.e.

1996). As the lead time increases, the relative predictive ability of the model for failed

firms decreases. About 62% predictive accuracy is observed as far back as six years prior

to failure. (See Table 3). It is therefore, suggested that this model is an accurate forecaster

of failure up to six years prior to failure. After this time period the prediction accuracy

has fallen quite low i.e. 52% for seven years and 42% for eight years prior to failure.

3.2.2. Logit model

Stepwise logit analysis is applied here to identify if a failure prediction model with better

accuracy than MDA model can be developed. The following logit model is developed in

this study:

Z = -4.68 – 5.302 X1 + 5.732X2 – 0.743X3 + 0.061X4

Where

Pr(1) = 1/1+e-z ,

X1 = net working capital / total debt (NWC/TD),

X2 = current assets / total assets (CA/TA),

X3 = sales / total assets (S/TA), and

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 X4 = net working capital / sales (NWC/S).

NWC / TD, CA/TA and S/TA are the variables that are also included in MDA model

while “T.Eq / T. Cap.” ratio in MDA model is replaced here with “NWC/S” ratio.

3.2.2.1. Ability of the model to separate failed and non-failed firms

Hosmer and Lemeshow goodness of fit test reveals how well this logit model fits into the

data. The Hosmer-Lemeshow statistic evaluates the goodness of fit by creating 10

ordered groups of subjects and then compares the number actually in the each group

(observed) to the number predicted by the logit model (predicted). Thus, the test statistic

is a chi-square statistic with a desirable outcome of non-significance, indicating that the

model prediction does not significantly differ from the observed. The 10 ordered groups

are created based on their estimated probability; those with estimated probability below

0.1 form one group, and so on, up to those with probability 0.9 to 1.0. Each of these

categories is further divided into two groups based on the actual observed outcome

variable (success, failure). The expected frequencies for each of the cells are obtained

from the model. If the model is good, then most of the failed firms in this study should be

classified in the higher deciles of risk and surviving firms in the lower deciles of risk.

The chi square value of 16.477 at 0.036 p-value indicates that the logit model prediction

does not significantly differ from observed in the original sample. Therefore it is a good

fit into the data.

3.2.2.2. Classification and validation tests accuracy

Logit model is applied on the firms included in sample to get their respective score. After

calculating Pr(1), firms with probability of failure ≥ 0.5 are classified as failed firms and

those with Pr(1) < 0.5 are classified as non-failed firms. See classification results in Table

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4. At 0.5 cutoff value, non-failed firms’ classification accuracy is 97.1% while failed

firms classification accuracy is 23%.

A validation test is also conducted to see if there is any search bias in the model. As

fewer numbers of failed firms are there in textile sector, Jacknife method is applied on the

firms in the initial sample. See results in Table 4. Classification accuracy of validation

test is about same as that of original sample classification test. Therefore it is suggested

that there is no search bias in the model.

3.2.2.3. Establishing a practical cutoff point

A cutoff value of 0.5 is used in classification and validation tests. But the classification

accuracy of failed firms is quite low at this value. A new cutoff point is therefore

identified that minimizes model’s expected cost function, i.e.

E(c) = WFEF + WSES (here WF = WS = 0.5)

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Classification accuracy for failed and non-failed firms and EC at different cutoff values

are presented in Table 5. The best cutoff value is 0.15 at which classification accuracy for

failed firms is 79.41%, for surviving firms it is 81.07% and EC is 19.76%. It is therefore

suggested to classify firms with Pr(1) ≥ 0.15 as failed while those with probability of

failure less than 15% as surviving firms.

3.2.2.4. Long range accuracy of the model

Logit model is applied on the five years prior to failure data of the firms in sample in

order to observe long range accuracy of the model. (See Table 6). It is observed that logit

model can accurately predict financial failure for two years prior to failure and the

predictive ability of the model falls sharply in the third year prior to failure.

4. Summary and Conclusion

Comparison of the models developed in this study reveals that the multivariate

discriminant analysis model performs better in terms of failure prediction accuracy and it

is therefore suggested as the final financial failure prediction model for KSE listed textile

firms. The classification accuracy of MDA model is 73.53% for failed firms and 85.43%

for non-failed firms at –0.55 cutoff value. While accuracy of logit model is 79.41% for

failed firms and 81.07% for non-failed firms at cutoff value of 0.15. Though

classification accuracy of logit model for failed firms is high as compared to that of MDA

model and expected misclassification cost function for logit model is also 19.76%, while

it is 20.52% for MDA model, but MDA model is recommended as the best failure

prediction model because of higher long range accuracy. Prediction accuracy of logit

model three years prior to failure falls to quite low level i.e. 53.13%. So, it can be said

that logit model is accurate in predicting financial failure only two years prior to failure.

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MDA model on the other hand, predicts failures quite accurately even six years before

failure. Therefore, MDA model can be used to identify that a firm will fail long before

actual failure occurs. The univariate analysis in this study reveals that the important

indicators of a firm’s failure are low liquidity, high leverage, and low profitability.

The limitations of this study are:

1. The commonly used terms for “financial failure” are default and bankruptcy. But

the data available for this study does not indicate when a firm defaulted on its

debt or entered into debt restructuring. Therefore, the financially failed firms in

this research are defined as those that ceased their operations and finally delisted

from Karachi Stock Exchange.

2. Though the financial variables found in the previous financial distress studies are

analyzed in this study but a number of such financial ratios can not be included

due to unavailability of data for calculating these variables e.g. retained earnings /

total assets, activity ratios, etc.

The model developed in this study is a predictor of financial failure but it does not tell us

about the causes of this failure. This is because the financial ratios used in the model are

actually the symptom of financial distress rather than its cause. For instance, poor

performance on profitability ratios reveals that the firm is facing profitability problem but

it does not tell what factors led the firm towards reduced profitability. The failure of a

firm may be caused by many different factors e.g. lower GDP growth, government

policies, lack of experience in the management, fraud etc. A number of causes of firms’

failure are not quantifiable, for instance fraud, lack of managerial experience, inadequate

control. Therefore further research can be conducted to identify what are the causes of

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failure of firms most commonly observed in Pakistan. For such research one must go for

primary data collection especially to identify the qualitative causes of failure because

secondary data about these factors is normally not available. It is difficult to collect such

data for the firms failed in the past, therefore one can apply model developed in this study

on existing firms and can go for primary research, e.g. case studies, surveys etc., on the

firms identified as prospective failures to know the causes of failure. The identification of

the most commonly observed causes of firms’ failure in Pakistan will help policy makers

to take steps to avoid these causes and as a result avoid the failure of firms.

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